RIIB

Topic:Credit Derivatives

GROUP MEMBERS• Chirag Ranka

129• Raj Jain128

• Shekhar Mehta107

• Prathamesh Thakar118

• Vijeta Sharma 109

• Vinayak Sukhatme123

Credit derivative • What is credit?

1. Lender2. Borrower3. Role of bank- extended credit

derivative• Underlying value of an asset

• Forward contracts • Futures contracts• Option• swaps

Options• gives the buyer the right • not the obligation• to buy or sell• a specified underlying• at a set price• on or before a specified date

Futures OptionsExchange Traded Same as futures

Exchange defines the product Same as futures

Price is zero, Strike price (futures price) moves

Strike price is fixed, Price moves

Price is zero Price is always positive

Linear Payoff Non Linear Payoff

Both long and short are at risk Only short at risk

Difference Between Futures and Options

Options• RIGHTS with the Buyer• OBLIGATION : SELLER

• The Buyer EXERCISES his Rights to buy or sell an asset in future. The Buyer purchases is a RIGHT from the Seller

• The Seller meets his OBLIGATIONS to sell or buy the asset in future

3 types of interest1.Subsidized interest2. Free market interest3.Other types such as • Cost of fund interest (PLR)• Based Rate• Bench Marked Rate• Libor Rate

Concept of bad loans

• Depends on Trust of Depositor and investors

• Financial system is based on trust.• NPA.

• E.g. American Financial System

Products offered in credit derivatives

• (CLN) Credit Linked note• It’s a promissory note and it is

negotiable.• A combination of a regular note (bond

or deposit) and a credit-option.• Created through a SPV.• Can be issued by any bank, financial

institution or NBFC.

CLN Issued by ICICI – Subscribed by UCO Bank

• The structure involves 150 Cr. loan portfolio of ICICI Bank through an SPV. The CLNs would be issued in 3 tranches - classes A, B and C. – Class A - CLN rated AAA issue size 80 Cr. – Class B - CLN rated AA issue size 65 Cr.– Class C - First loss position of 5 Cr.

CLN Issued by ICICI – Subscribed by UCO Bank

• Benefits to ICICI Bank– Can reduce exposure/ concentration on the

particular corporate / industrial sector to which bank is overexposed.

– Regulatory capital relief - The risk weighted exposure is reduced by the amount of funding received. The extent of assets collateralized by government securities is assigned a 0% risk weightage. First loss provision of 5 Cr. would attract a capital requirement with 100 % risk weight.

CLN Issued by ICICI – Subscribed by UCO Bank

– Pre-transaction regulatory capital requirement for ICICI would be CAR * risk weighted assets i.e. 9% x 100 % x 150 which is 13.5 Cr.

– Post-transaction capital requirement will reduce to provision for first loss piece as the class A and B are fully funded and hence attract 0 % risk weight, i.e. 5 Cr. Thus, there is regulatory capital relief of 8.5 Cr.

• Benefits to UCO – Can get synthetic exposure on good credits– Sectoral diversification

Credit Default Swaps (CDS)• Premium is loaded in loan price itself.• Protecting the loan by giving

guarantees in case it is defaulted.• Introduced in early 1990’s.• Effective tool for hedging.

• E.g. London banks giving loan of $ 4bn to TATA.

Credit Default Swap

A buyer (A) pays a premium (single or periodic payments) to a seller (B) but if a credit event occurs the seller (B) will compensate the buyer.

A - BUYER

Reference asset

premium

Contingent payment B-SELLER

Types of CDS

• Binary swap• Basket CDS• Cancelable default swap (callable CDS or putable

CDS)• Contingent CDS• Leveraged CDS

Types of CDS

Binary swap• Pre-default valuation• Fixed amount

Basket CDS• Multi-name reference• Suited to protection buyers who have a

better expectation about default frequencies

Cancelable default swap • Callable CDS • Putable CDS

Contingent CDS• contingent event; e.g. default on

another credit.

Collateralized Debt Obligations (CDO)

• Mortgage linked productE.g. AIG bailout.

1.Asset liability mismatch2.Create liquidity in balance sheet

Types of CDO’s• A) Based on the underlying asset:

Collateralized loan obligations (CLOs)Collateralized bond obligations (CBOs) Collateralized synthetic obligations (CSOs) Structured finance CDOs (SFCDOs)

• B) Other types of CDOs Commercial Real Estate CDOs (CRE CDOs)Collateralized bond obligations (CBOs)Collateralized Insurance Obligations (CIOs) CDO-Squared

Example of USA

• Mortgage failure• Non eligible people got loan• No income /cannot pay• Ninja• Hence….resulted into Subprime crisis.

Interest rate swaps• Only interest rate swaps• Only principal rate swaps• Currency swaps

Principle only Swap (POS)Principle Interest Swap (PIS)

(Forward Rate Agreement) FRA

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